Crude Oil and Gasoline Prices

Crude oil prices this week reached their highest level since last April. What will that mean for U.S. consumers at the gas pump?

The first question to be clear on is which crude oil price we’re talking about. Two of the popular benchmarks are West Texas Intermediate, traded in Oklahoma, and North Sea Brent. Historically these two prices were quite close, and it didn’t matter which one you referenced. But due to a lack of adequate transportation infrastructure in the United States, the two prices have diverged significantly over the last year.

My rule of thumb has been that for every $1 increase in the price of a barrel of crude oil, U.S. consumers are likely to pay 2-1/2 more cents for a gallon of gasoline. The yellow line in the graph below plots the average U.S. retail price of regular gasoline in the U.S. over the last 4 years. The blue line is the gasoline price you’d predict if you applied my rule of thumb to the WTI price (assuming 80 cents/gallon for average tax and mark-up), while the fucshia line gives the prediction if you assume that the U.S. retail price is based on Brent. The three lines were quite close until Brent began to diverge from WTI at the beginning of last year. Since then, the U.S. retail price has tracked the world Brent price much more closely than it has WTI.

Here’s a closer look at the data over the last year. Average U.S. gasoline prices fell more than you would have predicted based on the Brent price. They have since come back up. But Brent has surged another $10/barrel over the last two weeks, and gasoline prices have yet to catch up to that latest move. Based on the historical relation, we might expect to see the average U.S. gasoline price rise from its current $3.59/gallon up to $3.84.

One factor that’s been driving Brent and WTI up over the last few weeks has been rising tensions with Iran. But why should threats or fears alone affect the price we pay here and now? Phil Flynn, a senior market analyst at PFGBest Research in Chicago, offered this interpretation:

We’re seeing panic buying in Europe and Asia because they’re absolutely convinced that they’re not going to be able to buy Iranian oil or there’s going to be some kind of conflict that disrupts the transport of oil through the Strait of Hormuz…. there is a lot of hoarding in case the worst-case scenario happens. Asian buyers have been buying up West African crude like it’s going out of style.

Does it make sense for consumers to suffer now just because of something that may or may not happen in the future? If there are significant disruptions, the answer will turn out to be yes. We’ll be glad that we used a little less today, and left a little more in storage, to help us better cope with the huge challenges we’ll be facing in a few months. If the answer turns out to be no, then this is all just a lot of pain for nothing.

And which will it be? Nobody knows. But there’s a strong profit incentive for people who buy or sell crude oil or crude oil futures contracts to try to get it right. If it turns out that Iranian tensions do not escalate from here, anyone who buys oil at a high price today and sells low when tensions ease will lose big. If tensions escalate, those on the buy side will do well.

There’s obviously also an incentive for the world’s leaders to try to keep those tensions from escalating.

Personally, I have more confidence in the market getting this right than the politicians.

This post originally appeared at Econbrowser and is posted with permission.